"Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man." - Ronald Reagan

When approaching retirement the main question a retiree will try to answer is, "How much money do I need to cover my annual expenses?" While this is certainly a question that has to be answered, there is another one that must be considered as well: "What will my annual expenses be in 10, 20 or 30 years?"

The term "fixed income" is used far too often when discussing retirement investing and planning. Fixed income suggests you should be able to decide today how much income you are going to need each year of retirement. But because of inflation we know that our expenses are not going to be fixed, so we should not plan for our income to be either. If you plan to withdraw the same amount from your retirement account annually then you will be losing purchasing power each year due to inflation. And many people underestimate the effect inflation has on their retirement plans.

While we have seen wide swings of the inflation rate with highs above 10% in the late '70's and early '80's, the general rule of thumb is to plan for an annual rate of 3%. So how does that 3% affect your spending power over time?

Consider you are someone who is supporting a $60,000 a year lifestyle in retirement. At an average inflation rate of 3%, in order to have the same buying power in the future that you have today you will need:

$80,0000 a year in 10 years.

$108,000 a year in 20 years.

$145,000 a year in 30 years.

Flawed Retirement Investment Advice

Go to most online brokerage websites or talk to a financial planner and you're likely to get very similar advice in regards to retirement investments. They will likely tell you in some form or another that you should be seeking a diversified, income-focused portfolio that combine stock and bond investments that offer a choice of asset allocations designed to suit your age and risk tolerance. What this ultimately means for the investor who is trying to follow the 4% rule is that the portfolio will generate a small percentage of income and then you will need to sell some of your principle to make up the rest. The following year, assuming the portfolio generates a similar amount of income, the investor will have to sell once again as well as an additional amount in order to cover inflation.

Assuming the investor's portfolio value is increasing each year, this is a sustainable solution. Of course, what happens when the portfolio decreases in value? The investor still needs to increase the amount they are withdrawing to allow for inflation, but now they are increasing the amount they are selling from a portfolio that is decreasing in value. This is a double-whammy for the investor, and can create a significant problem for future withdrawals if the value continues to go down over a longer period of time. Those who were unfortunate enough to retire the past 10 years and follow this investing standard understand this danger all to well.

Dividend Growth Stocks Providing Inflation Insurance

Dividend stocks have gained in popularity the past few years for their ability to provide higher income in a low interest rate economy. But beyond focusing on the current dividend being paid by a stock, one should also take into account the growth history of that dividend. An investor who focuses on choosing companies that not only have a history of paying a dividend, but also a history of increasing their dividend each year will be able to effectively fight the threat that inflation poses on their retirement income. David Van Knapp wrote an article last year that answered the question "Has dividend growth kept up with inflation?" To summarize, he discovered that...

"There is no question that over very long time frames, dividend growth has handily exceeded inflation. Year-by-year, dividend growth was higher than inflation in 31 of 51 years. The average yearly rate of dividend growth (5.4%) exceeded the average annual inflation rate (4.1%) by 32%. Compounded over 51 years, dividend increases grew an initial amount by a total of 75% more than inflation."

What's even more impressive is that David's analysis utilized the S&P 500 to illustrate the broad trend. If you were to eliminate dividend paying stocks that did not have a history of increasing their dividend the dividend growth figure would have been even higher. Utilizing the inflation rates published here, we can see how some well-known dividend growth stocks have been increasing investors purchasing power over the past five years despite the effects of inflation. Note: Complete 2013 dividend and inflation figures are estimated.

Now let's see how well some of the most common income mutual funds, that are specifically designed to provide investors with retirement income, have performed in regards to inflation protection from 2008 to 2012. Note: Special dividends are not included. All data came from www.morningstar.com

PIMCO Total Return Fund (PTTRX) is the largest fixed-income mutual fund that is most used by defined contribution plans. It has a 0.46% annual expense fee that was not included in the calculation.

2008

2009

2010

2011

2012

Dividend Growth

2.31%

8.82%

-40.54%

2.23%

-0.42%

(minus) Inflation

3.85%

-0.34%

1.64%

3.16%

2.07%

Purchasing Power Change

-1.54%

9.16%

-42.18%

-0.93%

-2.49%

Fidelity Strategic Income (FSICX) was created to "seek high level of current income." It has a 0.70% annual expense fee that was not included in the calculation.

2008

2009

2010

2011

2012

Dividend Growth

-17.26%

4.92%

-2.63%

14.84%

-25.50%

(minus) Inflation

3.85%

-0.34%

1.64%

3.16%

2.07%

Purchasing Power Change

-21.11%

5.26%

-4.27%

11.68%

-27.57%

T. Rowe Price Retirement 2010 (TRRAX) is a target date fund that is specifically developed for investors who retired between 2000 to 2010. It has a 0.61% annual expense fee that was not included in the calculation.

2008

2009

2010

2011

2012

Dividend Growth

-2.50%

0.00%

-10.26%

5.71%

2.70%

(minus) Inflation

3.85%

-0.34%

1.64%

3.16%

2.07%

Purchasing Power Change

-6.35%

0.34%

-11.90%

2.55%

0.63%

Conclusion

If you're relying on mutual funds to generate retirement income or are currently holding your retirement savings in cash or low-rate investments you need to consider the effects inflation is having on your future spending power. Stock dividend increases aren't a guarantee, of course. But given a choice between an absolute certainty that your buying power decreases due to inflation over time and a strong chance to keep pace or exceed inflation that's backed up by decades of evidence, investors would be wise to make dividend growth stocks a core holding in their retirement portfolio.

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